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By Neal Dihora

The Budget Control Act of 2011 outlined cost reductions to offset U.S. debt ceiling increases of as much as $2.1 trillion in multiple steps: $400 billion immediately, $500 billion a bit later, and the remainder after Congress enacts further reductions. The initial tranche of spending limitations totaled $917 billion over 10 years, which would cover the first two boosts to the debt ceiling. The final advance would require further cuts that could total $1.2 trillion-$1.5 trillion. Since the bipartisan supercommittee tasked with identifying the reductions announced its failure to come up with a compromise in late November 2011, the law currently on the books will require across-the-board cuts of $1.2 trillion to begin Jan. 2, 2013 -- otherwise known as sequestration. In our previous article, we examined the impact of the cuts to the defense budget and emphasized aspects of the sequestration cuts that are set to hit the defense sector in a meaningful way. In this article, we take a closer look at the effect the cuts could have on the defense companies we cover.

Potential Outcomes

We think there is some likelihood that Congress will delay the impact of the sequestered cuts into the future, perhaps by three or six months, following the fall election. We think a delay would represent a victory of sorts for the defense industry because companies are currently unable to plan for any significant cuts; therefore, the status quo doesn't pressure revenue or operating margins for some time. Many companies have reduced workforce and facility exposure where possible, but plenty of "unknown unknowns" remain outside the planning purview.

We could yet see a compromise to avoid sequestration entirely and fix the budget deficit issues that have brought us here. We don't think this is likely, given Congress' inability to do so over the past two years.

Should sequestration cuts actually be implemented, we think confusion would reign. We note the following from the Government Accountability Office in its "Compliance Report for FY 1986: Balanced Budget and Emergency Deficit Control Act of 1985": "We found widespread confusion among agencies in applying the program, project, and activity definitions." This assumes, of course, that the Office of Management and Budget presents a methodology for implementation.

Prime Defense Contractor Sales Trends

Here we discuss details of the five large defense companies: Lockheed Martin (LMT), Boeing (BA), Northrop Grumman (NOC), General Dynamics (GD), and Raytheon (RTN). The end markets for these companies include commercial, government, and international customers. The following table outlines the recent sales performance by company. For Boeing, we have only included its defense business. The table shows that most participants continued to see growth in 2011 -- Northrop Grumman's loss was due to portfolio-shaping activities -- but 2012 depicts the difficult spending environment we may be entering for some time.

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Still, it is important to note that the companies have done a good job of planning ahead of the revenue declines. The following table outlines the operating margin rebound gaining steam following the nadir in 2008. This management underpins our projections, as we assume that each of these companies will be able to move ahead of lower sales potential. However, the near term remains foggy, and we believe a sequestration-type outcome would probably limit flexibility over the short term.

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Information Technology Exposure

In an environment of constrained budgets combined with limited visibility, we believe IT and services are more negatively affected than long-cycle businesses such as shipbuilding or aircraft acquisition. In periods of budgetary inconsistencies, purchasers have limited ability to procure services for fear of lack of funds, and they begin to prioritize projects. For example, multiple defense companies have commented that a lack of federal money has resulted in lower sales or more difficult operating circumstances for IT services.

In the following table, we include data that show sales of IT through the years. The United States had continuing resolutions for fiscal 2011 and 2012, and one is expected for fiscal 2013. The table highlights the slowdown in IT segment sales over those three affected years (2010, 2011, and 2012). This segment represents a large part of total sales for all five players. In fact, Lockheed Martin is the largest IT provider to the U.S. government, and IT is General Dynamics' largest segment. We see this segment continuing to struggle with the budgetary issues at the Department of Defense and the government overall.

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Importance of International Sales

Many of the defense players have been able to grow through sales to international clients. A similar strategy was used during the defense reductions of the 1990s, and the market has been robust with strong sales to Asia and the Middle East. The following series shows international sales, percentage contribution, and growth. We then follow with sales excluding international sales and the growth of the business without revenue from abroad. The view is clear that international has been, and will probably continue to be, a leading driver of growth.

Invest With Caution

Defense companies look cheap on a price/earnings basis, and some have juicy dividend yields. However, we remain concerned that should Congress fail to avert the upcoming cuts, the businesses will suffer sales and operating profit declines, leading to lower share prices. We don't believe the law currently in place is reflected in market prices, and we're cautious on the sector.

However, General Dynamics appears attractive based on our fair value estimate. We believe the company is being negatively affected by its exposure to the Army and IT, both of which are likely to suffer as the U.S. pulls out of conflicts and uncertain budgets constrain short-cycle procurement. We like its diversified businesses, but we'd wait for the stock to hit 5 stars before investing. Similarly, Raytheon offers limited exposure to IT and high exposure to international sales, a combination that could drive upside sales potential vs. our estimates.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: What Sequestration Means For Defense